Cree’s Earnings Point Toward Growing LED Adoption

Despite macro headwinds and the slow adoption of LEDs, Cree (NASDAQ:CREE), one of the leading LED manufacturers, reported another quarter of strong earnings with an annual growth of 14% and 69% in revenue and net income for its latest quarter, respectively. New product innovation across its LED and RF product portfolios enabled both business divisions to exceed Cree’s revenue target in Q2.

Despite declining LED selling prices, Cree registered close to 4% annual increase in gross margins on account of improved production mix as well as higher productivity yields. A surplus in the LED market, a consequent decline in prices and pressure on margins are some of the key trends currently plaguing the LED industry. While a demand-supply mismatch restricts Cree’s topline growth, high R&D cost and operating expenses threaten its bottom-line.

However, witnessing an increase in orders for all its business divisions, Cree claims that the LED market dynamics are improving. Cree remains committed to drive LED adoption and aims to close down the gap with conventional lighting via increased innovation. With $866 million in cash and investments and no debt, we feel the company is well-equipped to continue investing in LED research and leverage potential growth in the LED market. (Read Our Article: Growth Potential In LED: Factors Driving Cree’s Valuation)

Though there still remains some excess capacity in the LED market, Cree saw a 12% increase in LED revenue. While the LED components registered a 4% y-o-y increase, the lighting products business segment grew at a robust 28% (y-o-y).

As LED demand from the backlight market nears saturation, potential growth in the LED lighting market is estimated to fuel future growth in the LED industry. With new product offerings, Cree’s indoor and outdoor lighting industry witnessed stronger than expected growth in Q2 2013.

Cree remains focused on driving LED adoption and growing sales of its indoor and outdoor products. We feel that its acquisition of Ruud Lighting, a leader in outdoor lighting, in mid-2011 allows it to extend its leadership in indoor as well as outdoor lighting.

Cree has a fully integrated vertical lighting model and intends to continue working on building new lighting systems to reduce the cost of LED lighting and improve payback.

The LED market remains competitive and Cree anticipates some softness in demand due to the Chinese new year holiday and the slowdown in outdoor lighting sales in cold-weather regions during the current quarter. However, we expect this to be a temporary trend and anticipate higher LED and lighting adoption in 2013.

Improvement In Gross Margins

While Cree’s gross margins increased significantly in 2010, they declined close to historical levels of around 37% in 2011. The downward pressure resulted from a combination of factors, namely the decreasing selling prices and the high operating expenses as Cree stepped up R&D efforts to close down LED gap with traditional lighting.

However, last year Cree witnessed a continuous improvement in gross margins. In Q2 2013, its gross margins increased to 38.5% on account of factory cost reduction, improved production yields, lower cost of new products and higher factory utilization owing to increased demand.

While Cree continues to make incremental investments each quarter, improved factory efficiency have eased pressure off margins. We expect that as adverse macro conditions subside and demand picks up, higher revenues for a similar cost base would lead to a slight increase in margins this year. However, with intense competition, we expect margins to remain range bound for the rest of our review period.

Higher Selling Expenditure In The Future

Cree remains committed to its goal of finding new ways to drive broader LED adoption and build global awareness for its brand. To promote its new products in the market, the company intends to increase its marketing spending over the next few quarters.

LEDs currently account for only 10% of the total lighting market. ((Lighting the Way: Perspective of the global lighting market, McKinsey Report)) To increase LED adoption and drive sales of its new products, we feel that Cree will have to incur high selling, general and administrative expenses for the rest for our review period.

Outlook For Q3 2013

- Revenue in the range of $325 million to $345 million, driven by seasonal trends in LEDs

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